Future of Student Loan Rates Unclear

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. The interest rate on a popular student loan type is set to go up at midyear, barring congressional action. Joining me to discuss this and other college-funding news is Adam Zoll. He is assistant site editor for Morningstar.com. Adam, thank you so much for being here.

Adam Zoll: Thanks for having me.

Benz: We're set to see the subsidized Stafford loan rate jump up from 3.4% currently to 6.8% at midyear, barring congressional action. Adam, let's talk about what is a subsidized Stafford loan?

Zoll: A subsidized Stafford loan is a loan available to students from lower-income families who demonstrate a financial need to pay for college. It affects more or less about 9 million students per year.

Benz: So it would affect already-existing loans or just new loans?

Zoll: This would only affect new loans for the upcoming school year. Existing Stafford loans would still be at their current rates.

Benz: Now, Adam, the president's recent budget proposal also included some proposals regarding student loans. Let's talk about what was in there.

Zoll: Sure. What's really significant about the president's proposal is that for the first time it would tie student loan rates to market-based rates. Previously these rates were set by Congress. What the president is proposing is to use the 10-year Treasury note yield as sort of a basis for calculating these other loan rates. So the subsidized Stafford loan would be about 1 percentage point above that market rate. The nonsubsidized Stafford would be 3 points above, and the Parent PLUS loan would be 4 points above. So for the first time these student loan rates would be more in sync with overall interest-rate movements.

Benz: So they'd float along with the prevailing interest-rate environment.

Zoll: Right. It's important to know, they would change year by year, and they would be fixed [to interest rates] for the life of the loan. So they are not a variable-rate loan. But the rate would change year by year based on what the market is doing.

Benz: So right now that actually might be a good thing for people taking out these loans; the rates might actually be lower than where they are at 3.4% and 6.8% currently. But if rates trend upward, that could become a problem.

Zoll: That's the concern of people who are critical of this plan, is that once rates do start to rise, students and their parents could end up actually paying higher rates than the rates set by Congress. So that's a real concern.

The response to people in the president's proposal is that the income-based repayment structure would be broadened, so that students would not be required to pay more than 10% of their discretionary income in a given year to repay these loans, and then there would be a 20-year cap as long as people stay good on their loan repayments. So the argument is that that would have sort of an effect to reduce the impact of potentially higher rates. But it's an interesting argument back and forth. Tying these loan rates to the market does have Republican support, so it's a case where the president and the Republicans are on the same side. So it would seem to give this proposal some legs of possibly happening.

Benz: One other big headwind for college savers and their parents is the declining expenditures that we've seen some states make on higher education. Let's talk about that trend there. It seems like one of many sobering trends in the college-funding landscape.

Zoll: Right. One reason that college tuition rates have been rising as fast as they are is that states have not been putting the money toward public universities and colleges, the way they have historically. In fact, the Center on Budget and Policy Priorities did a study that found that since 2008, on average, states have cut spending on their public colleges by 28%, or about $2,300 per student. This, obviously, has a trickle-down effect in terms of what the colleges end up charging students for tuition.

During the same time, annual tuition at these four-year public schools has risen by about 27%. So we are definitely seeing states pulling back. It should be noted that the study going back to 2008, that was when the recession was really starting to kick in, since the economic recovery has started to take place, states' revenues are also starting to recover, and it will be interesting to watch and see if states start to restore some of these funding cuts to colleges and universities.

Benz: State budgets are still under pressure, obviously. One other item of note is, in the 529 college-savings plan landscape., when you look at some of these plans, what you're seeing is that some states are getting out of the advisor-sold market. Let's talk about that, and what's driving that trend.

Zoll: Right. Well, recently, Mississippi announced that it was discontinuing its advisor-sold 529, and this is a small plan with only $15 million in assets. So it's not maybe surprising that they would be changing their structure there. California discontinued its advisor-sold plan in 2011.

But research from Morningstar's 529 team has found that the amount of assets in advisor-sold 529 plans versus direct-sold plans is starting to tilt ever so slightly in favor of direct-sold plans. So it was about 51/49 a couple years ago for advisor-sold plans; now it's 51/49 the other way. Advisors, of course, have the option of using the direct-sold plans, which tend to be more index-based, cheaper options for their clients. So the fact that we're seeing slightly more assets in the direct-sold plans doesn't necessarily mean people aren't using their financial advisors to invest in 529s. It means that more people are looking at these lower-cost options.

Benz: One other bit of 529 plan news, actually some good news here, we've seen plan assets increase quite a bit. Let's talk about that.

Zoll: Well, the College Savings Plan Network released its annual report. It found that 529 assets reached an all-time high in 2012 of $190 billion. That's up from $105 billion since 2008, and of course, we've seen a bull market in stocks since that time, which gets the credit for some of that increase.

But even factoring that out, there seems to be an increase in people's contributions to these plans. The average account size rose from 2011-12 about $15,300 to $17,100. So people are getting the message I think that the cost of college is going up and that you need to be able to save. At the same time, $17,000 is maybe good for one year at an in-state public college. So people need to be saving more in order to prepare themselves unless they want to be subject to these loans that we were talking about at the outset. But at least it's showing an incremental improvement in terms of people growing their 529 savings accounts.

Benz: Adam, great insight, great advice. Thanks for being here to discuss college.

Financial planner Mark Balasa and Morningstar's ChristineBenz and David Blanchett tackled viewers' most pressing retirement questions, from determining savings rates and income needs to planning for Social Security and maximizing retirement accounts.